Yesterday, the Senate defeated an amendment that would have allowed judges to change terms on mortgages during bankruptcy proceedings. This is being touted as a good thing by conservatives, but is it? Let's put aside partisan politics and take a close look at the situation.

The primary conservative argument is that of contract law.  As Morrissey says at Hot Air:

That is the bigger principle at stake. We are supposed to be a nation of laws, and contract law is supposed to be binding. No one signs a mortgage with a gun at their head. Durbin and his allies want to end the notion that contracts mean what they say. Instead of binding agreements on which people can rely, contracts will become much like the Constitution for the Left — meaning whatever seems expedient from moment to moment.

Removing the political context, I agree with the substance of this.  In the normal course of business, one must not be allowed to break contracts willy-nilly.  However, bankruptcy is not the normal course of business.  Bankruptcy is a very special case, where one's liabilities exceed one's assets, with insufficient cash flow to service debt.  Personal bankruptcies can be due to bad luck, illness, financial mismanagement, or a host of other things.  In the case of financial mismanagement, quite often the lender will be complicit in the bankruptcy, through the extension of imprudent credit.

A bankruptcy can be very difficult to sort out, with competing claims by creditors against assets that can be difficult to value.  This is why we have bankruptcy courts.  So, let's assume a simple case:  Joe Blow bought a house for $500,000 by taking out a fixed-rate non-recourse secured loan for $400,000, with a 2nd to finance his down-payment.  His house is now worth only $300,000, he has no savings, and $20,000 in additional credit card debt.  The poor guy also lost his job and his dog ran away (just to give it that country music flavor).  The simple facts of the case:  He has debts of $520,000 against assets of $300,000 (assuming for simplicity his posessions are worth almost nothing), and no way to service his debt.  Joe Blow is tapped out and headed for bankruptcy court.

What are the possible outcomes?

1. Typically, the court will agree to let the bank foreclose on the house, leaving the bank with a physical asset instead of the $400k loan and a 2nd worth zero.  The credit card company gets stiffed.
2. Alternatively, the court could order a liquidation of the assets and pay creditors according to the seniority of the debt.  So, the house sells (eventually, maybe) for $300k of which the bank gets everything (the $400k secured loan is primary), the 2nd is written off, and the credit card company of course gets stiffed.  Given the typical mortgage contract, this will almost never happen.
3. Under a cram-down rule, the judge could simply order that the house is now worth $300k and that the bank's $400k loan is now worth $0.75 on the dollar (note that this happens in corporate bankruptcies all the time).  Now the bank has a decision to make.  Assuming Joe still has no way to service debt, the end result is going to be the same as (1) above.  However, perhaps Joe has gotten a new job in the meantime, and it's a job that would allow him to service the debt on a $300k loan, plus make payments against a lowered 2nd and even some payments against a lowered credit-card debt.  Joe gets to keep his house, his dog comes back, and while he'll need to rebuild his credit rating, this would seem to be the best deal for everyone.

So, from a practical standpoint, we can see that, at worst, the cram-down won't make any difference, and at best might help everyone involved.  Ahh, but we don't live in a practical world, do we?  Why are banks so opposed to a cram-down rule for mortgages when the same type of thing happens in corporate bankruptcies all the time?

The answer is simple:  In case (1) above, the bank has an asset against the original $400k loan, that it can still keep on the books at or near that level.  Eventually, of course, it will have to dispose of this asset, but it allows the bank to decide when to take the write-down (if needed) or perhaps hold on to the asset in hopes of appreciation (which the bank now gets rather than Joe).  Of course, the bank has to eat any further losses, but they were on the hook for that regardless.

In cases (2) and (3) above, the bank has to realize a loss immediately, and even though (3) would improve their cash-flow position going forward (and let the credit card company participate), they won't want to take that loss.  Why?  Becase the bank is also tapped out and can't afford the hit to capital.  So, in the interests of continuing the sham of major bank solvency, a less-than-optimal overall economic result occurs.

I understand the emotional desire to punish those who leveraged their lifestyle and took out loans they couldn't afford.  I've been resposible, have zero debt, and am paying for this whole fiasco as much as anyone.  However, I find the arguments against cramdown in bankruptcy to be naieve.  At the end of the day, not allowing for mortgage cram-downs in personal bankruptcy merely prolongs the agony of the big banks, and protects them (and their bondholders) from their bad decisions, against broader societal (taxpayer) interest.

This will probably be the one and only time I agree with Dick Durbin, but the cram-down amendment should have passed.

Posted by: Hermit Dave at 02:02 PM | No Comments | Add Comment
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